The debt ratio measures the company’s level of debt relative to the value of its equity.
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The debt ratio for a company is the ratio of debt to equity. It is part of the financial ratios.
The debt ratio or ratio is a concept applicable to a company but also to a household. We focus here on the company.
What is debt and what is it for?
Indebtedness is a means of financing a company, like the capital increase and self-financing.
Debt is sometimes useful if the company does not have sufficient equity. In some cases, debt is a cheaper method than others to finance new projects.
Debt is composed of bank debts, but also operating debts, and non-operating debts, such as taxes and social security contributions.
How to calculate the debt ratio
The general debt ratio of the company, the financial debt ratio and the net debt ratio can be calculated.
Calculation of the general debt ratio
The formula for calculating the general debt ratio is:
General debt ratio = total debt / equity
Shareholders’ equity includes the company’s capital, profit reserves that have been reinvested and the result of the previous financial year.
Calculation of the financial debt ratio
We can also calculate the financial debt ratio:
Financial debt ratio = financial debt / equity
Financial debts mainly include loans, bank loans, receivables sold but not yet due, cash advances, etc.
Calculation of the Net Debt Rate
The debt ratio can also be calculated more precisely, in this case the net debt ratio, with the formula:
Net debt ratio = Net debt / Equity
Net debt refers to all bank and financial debts, both long-term and short-term, less cash, ie cash. Equity is shown on the liabilities side of the balance sheet.
Usefulness of the debt ratio
The debt ratio of the company should be as low as possible. The higher the rate, the more the company is in debt, that is, the larger the debts it has to the assets it has to deal with it.
- A high debt ratio has an impact on the cash flow of the company because it is accompanied by fixed costs, such as amortization of loans and interest.
- A very low debt ratio may mean that the company is too cautious, unwilling to invest or take risks, which can be judged negatively by potential investors.
Debt ratio and solvency
Like, for example, the repayment capacity, the debt coverage ratio and the liquidity ratio, the debt ratio is one of the tools used to measure the solvency of a company.
Solvency is the ability of the company to pay what it owes on the due dates. A company with low creditworthiness may be in default.
The calculation of the debt ratio also makes it possible to compare the solvency of different types of businesses across various sectors of activity.